The Centre for European Reform is a think-tank devoted to improving the quality of the debate on the European Union. It is a forum for people with ideas from Britain and across the continent to discuss the many political, economic and social challenges facing Europe. It seeks to work with similar bodies in other European countries, North America and elsewhere in the world.

Thursday, December 18, 2014

For the last decade, relations between the EU and Israel have been strained by tension over the Middle East peace process, but strengthened by intensive scientific and economic co-operation. So far, confrontation has not crowded out collaboration, but with the EU’s decision to get tougher on Israel’s settlements policy, this may change. Both Israel and the EU will need to find a balance between their disagreements over the settlements and the beneficial economic and scientific co-operation. They can take a number of steps in order to achieve this.

The positive aspect of the relationship is not often recognised. Economic and research links between the EU and Israel are strong. In 2013, the value of EU-Israel trade was €29.5 billion (equal to 13.7 per cent of Israel’s GDP), with €12.5 billion imports to the EU and €17 billion exports to Israel. The EU is Israel’s main trading partner, accounting for one-third of its total trade. Large Israeli corporations have sizeable investments in Europe and employ many Europeans, while Israel, despite its small size, is one of Europe’s most important trading partners in the Middle East. It supplies Europe with high-tech products, including software and apps used in most PCs and smartphones, medical devices, chemicals and pharmaceuticals (Israel’s TEVA is one of the most important sources of generic medicines for Europe).

Beyond trade, Israel and the EU have been collaborating in fields such as agriculture, aviation, science and in a wide variety of R&D fields (including nanotechnology, health, environment and communications). Israel participated in the latest EU R&D Framework Programme (FP7) and in June 2014 it joined the EU’s research and innovation programme, Horizon 2020, and will contribute to its budget. Hundreds of leading Israeli institutions have received EU funding for innovative research, in many cases sharing their expertise and knowledge with their European counterparts.

There are also defence ties: Israel conducts joint military exercises with Bulgaria, Greece and Italy, while some EU member states, including Germany, the UK and Italy trade defence goods and services with Israel. In addition, Israel’s intelligence agencies and their European counterparts (among them agencies in the UK and Germany) collaborate closely.

But alongside that co-operation, political tension, rooted in the Israeli-Palestinian conflict, is increasing. Issues such as the political status of Jerusalem, human rights, the humanitarian situation in Gaza and EU funding for left-wing NGOs in Israel have been troublesome.

The EU and Israel also disagree on the timetable for peace. While many European leaders believe that now is the moment to push for an agreement, Israeli politicians often stress the current instability in the Middle East. Moreover, Israelis remember the 2005 withdrawal from Gaza and fear that leaving the West Bank will only lead to a ‘second Gaza’ under Hamas rule or turn it into fertile ground for jihadist movements.

The issue of Israeli settlements in the West Bank undoubtedly casts the longest shadow. European leaders criticise new houses and neighbourhoods built beyond the 1967 borders. They fear that Israel’s actions undermine the territorial integrity of a future Palestinian state, thus making it harder to achieve a two-state solution. Many Israeli politicians, on the other hand, argue that the real obstacle for peace is not the settlements policy but rather the absence of a credible Palestinian partner who is willing to compromise.

Since 2012, the EU’s attitude towards Israeli settlements in the West Bank has become more assertive. This is reflected both in rhetoric and policy. For example, recent statements issued by the European External Action Service (EEAS), say that the settlements “constitute an obstacle to peace” and “question Israel’s commitment to a peaceful negotiated settlement”.

In practical terms, the EU has published strict new guidelines for EU grants, preventing Israeli entities located in the West Bank from receiving EU funding. Additionally, the EU no longer recognises Israeli veterinary services in the West Bank, which in practice prevents the export of dairy and poultry products from settlements to Europe. According to media reports, EU officials are considering applying additional ‘sticks’ in the future if construction continues, among them labelling Israeli products produced in the West Bank and requiring visas from Israeli settlers.

While these European policies are limited in scope, they damage the dialogue between Israel and the EU, especially with a right-wing Israeli government. They may also discourage bilateral co-operation in other areas. Last year’s negotiations on Israel’s participation in the Horizon 2020 programme shows how things can snowball.

During the negotiations, the EU wanted to ensure that European funds would not reach Israeli institutions located in the West Bank, East Jerusalem or the Golan Heights. The Israeli newspaper Haaretz reported that tough meetings took place within the Israeli government; some ministers supported signing the agreement, among them Finance Minister Yair Lapid, while Foreign Minister Avigdor Lieberman and his deputy Ze’ev Elkin argued that Israel should not participate in the programme. They felt that by signing, Israel would de facto acknowledge that the settlements were illegal. For his part, Prime Minister Benjamin Netanyahu raised the possibility of attracting alternative funds from Asia and North America in order to compensate Israeli research institutions.

What started as a discussion about access to Horizon 2020 funds soon became a political argument, creating tensions that had the potential to damage fruitful scientific collaboration. Israel’s academic and research institutions could have lost millions of euros in research grants, as well as access to European knowledge and markets. The EU would have lost one of its most innovative and successful scientific partners.

The Israeli media give more coverage to such disagreements than to co-operation with Europe. Israeli politicians, academics and diplomats have accused the EU of dealing with Israel unfairly, by only pressuring Israel for concessions, and of not understanding the mentality of the Middle East. Furthermore, the increasing number of anti-Semitic incidents across Europe and boycott campaigns in European universities and companies receive significant media attention in Israel. Although these incidents are often condemned by European leaders, they reinforce Israeli mistrust.

The case of Horizon 2020 however, also shows how tensions can be managed. Amid the crisis, prominent Israeli academics, including heads of Israeli universities, members of the Israeli Academy of Sciences and representatives from the Committee of the Council for Higher Education (the state body responsible for distributing higher education funding) repeatedly urged the government to sign the agreement; they were worried about the implications for Israeli research. This pressure eventually paid off. The Israeli government showed some flexibility and a diplomatic agreement was reached: EU regulations will be respected and funding will not flow to settlements, but Israel added an annexe to the agreement stating that it disagrees with the EU’s legal position concerning the settlements.

Other parties can also play a role in calming tensions and preventing future rows about EU policy towards Israeli settlements from damaging collaboration. First, high-tech and medical businesses in Europe and Israel should speak up in times of political friction about the direct benefits they get from a good relationship.

Second, the EU’s representatives have to voice more clearly what they are trying to do. The EU’s guidelines and demands concerning Horizon 2020 were portrayed by some Israeli commentators as part of a ‘European boycott’; but in fact the EU made a legitimate decision not to fund organisations in Israeli settlements in the West Bank, which violate international law. The EU should make clear that, in areas of productive co-operation where there are not the same legal issues, it will do its best to maintain the relationship. It should emphasise the positive contribution that the EU brings to the daily lives of Israelis. For instance, the EU-Israel ‘open sky pact’ reduces the prices of airline tickets for Israelis; its funding for institutions based within the 1967 borders boosts Israeli research and jobs; and the EU-Israel free trade agreement has a positive effect on Israel’s market.

Third, Israeli and European politicians should focus on quieter, pragmatic dialogue, rather than play to the crowd. Member-states, the Commission and the EEAS all have a role to play in managing the relationship and talking frankly about disagreements. Federica Mogherini’s first visit outside Europe as High Representative for Foreign Policy was to Israel and the Palestinian territories. She stated that she intended “to use the Union’s political potential in this region”, which suggests that she plans to continue (or even deepen) the dialogue and the EU’s involvement. Israeli senior politicians should commit to doing the same.

These tools should allow both parties to manage some of the tensions and hostility that have emerged in Israel as a result of the EU’s stance on the settlements. In the long run, however, without meaningful progress in the Middle East peace process, and with more settlements under construction, the EU may be tempted to be tougher. This could translate into more restrictions on Israeli entities located outside the 1967 borders. The longer the status quo remains, the greater the chances of such EU actions. This should be cause for alarm, particularly in Israel. Although the benefits of the relationship are mutual, they are not symmetric; Israel is much more reliant on Europe than vice versa. Turning a deaf ear to Europe’s complaints could be a costly mistake for Israel’s leaders.

Yehuda Ben-Hur Levy is a Clara Marina O'Donnell fellow at the Centre for European Reform.

Tuesday, December 16, 2014

On recent visits to Berlin, I have been surprised at how negative people are about France. Key officials regard the country as incapable of controlling spending or enacting serious structural reform. They do not show much understanding of the political constraints that limit President François Hollande’s freedom of action. The officials add that, so long as the mistrust between Berlin and Paris persists, they cannot strike a bargain to strengthen eurozone governance. In any case, they say, there is no urgent need to do so, because – in their view – the eurozone as a whole is not in crisis. There are just specific problems in a few countries like France and Italy, caused by politicians lacking the courage to do what is necessary.

So I went to Paris to discover what the government thinks about Germany and the future of the euro. In Paris there is a sense of urgency about the stagnation of the eurozone (which is likely to grow at less than 1 per cent this year and to do not much better next year), the deflation afflicting parts of it (prices are falling in France) and the negative impact that these problems will have on French growth, job-creation and debt sustainability. Even French officials who are life-long believers in Franco-German amitié admit that the relationship is now ragged and horribly unbalanced: on the big questions, Germany sets the agenda for the eurozone.

Among the questions being considered by the French government are: what is the best way of influencing the Germans; whether the economic thinking in Berlin and Frankfurt may evolve to become less anti-Keynesian; whether the presence of the SPD in the German government could prove helpful; and how eurozone governance should be improved.

There are divisions on how to deal with the Germans. The predominant view is that France has a credibility problem with Berlin. Therefore it should show some results on implementing reforms and controlling spending, before taking on Berlin on eurozone governance. The other view is that the economic situation in France and in the eurozone is so dire that the Germans need to be confronted right away.

Everyone in the government is upset that Commissioner Günter Oettinger in the Financial Times and Chancellor Angela Merkel in the Welt am Sonntag criticised France for neither reforming nor complying with EU budget rules. This finger-wagging reinforces the narrative in France that Hollande and Prime Minister Manuel Valls have to reform to keep Berlin happy – whereas their line is that reform is good for France. Some of those close to Hollande think the criticism unfair, given that, as they see it, France is doing a lot to reform: the Loi Macron promises to deregulate professions, shopping hours and coach services, while the social partners are due to hammer out new labour market rules in January. But others point out that many Socialist deputies – and even some ministers – oppose these reforms for being too libérales and may well succeed in watering them down.

French officials worry about the intellectual gulf that separates the thinking of Germany’s financial and political elite – which emphasises the supply side to the exclusion of demand, and rules rather than macro-economics – from most of the rest of the world. In particular, they worry about the Germans’ reluctance to analyse the eurozone economy as a whole, rather than as a series of national economies; about their indifference to deflation; and about their rejection of the principle that an economy can suffer from a lack of demand that requires a macro-economic stimulus. They lament that so many key officials in the Chancellery and Ministry of Finance are lawyers rather than economists.

The French find the Germans more uncompromising on their economic philosophy than they were a few years ago, and less prepared to accept that they might be wrong (the recent downturn in the German economy has not been harsh enough to prompt many Germans to reconsider their views). Therefore when Germany has to compromise in the EU, for example on budget deficits, it does it out of political necessity, not because it admits to any chinks in its argument. As one official puts it, “the Germans don’t think economically, but judicially and in terms of rules and the rapport de forces”.

This intellectual divergence makes it hard for Berlin and Paris to agree on the next steps for the euro. At a time of supreme German self-confidence, the French are particularly unwilling to contemplate a new treaty or revision of the eurozone rules – because they think the Germans would write them.

Economy Minister Sigmar Gabriel, the SPD leader, has disappointed Paris. Intellectually, he doesn’t follow the hard line of Finance Minister Wolfgang Schäuble on the need for austerity in the eurozone. But he is not prepared to argue for a softer line in public, lest the SPD alienate German voters.

Some French officials credit Gabriel with helping to persuade Schäuble to make a small shift by accepting the case for more investment in Germany. Other officials think they have succeeded in changing the thinking of their opposite numbers in Berlin on the need for more investment at eurozone level. But they recognise that this supposed intellectual shift has not yet led to significant new policies for the eurozone or Germany. The Germans still think structural reform is the only really effective way to revive growth. And they have ensured that Commission President Jean-Claude Juncker’s €315 billion plan to boost investment contains little new money (the idea is to lever €21 billion from the EU budget and the European Investment Bank).

As always, there are frequent gatherings of French and German ministers and officials, but these are not bringing about a meeting of minds. Recently, the four ministers of economy and finance produced a joint paper on the need for more investment in the EU, France and Germany, but it said little that was new. Gabriel and Macron also commissioned Henrik Enderlein and Jean Pisani-Ferry, two eminent economists, to write a report on ‘Reforms, investment and growth: An agenda for France, Germany and Europe’. This called on each country to take a series of steps, for example for the Germans to boost public investment and the French to introduce more flexible labour markets. But the ministers have only weakly endorsed the report, given that its recommendations are controversial, and for now it is not being translated into political action.

October’s European Council asked the ‘three presidents’ (of the Commission, European Council and European Central Bank) to prepare a report on the future of the monetary union. This will put eurozone governance on the agenda in 2015. Given the strained state of the Franco-German relationship, however, there is not much optimism in Paris about what this exercise may achieve. In any case, the French do not currently have a set position on eurozone governance. Nevertheless they are mulling over a number of ideas. These include:

Inserting more economic analysis into the EU’s process of vetting national budgets. Officials are vexed that when the Commission recently looked at the French budget, it carried out no analysis on the economic impact of different possible budgets. The decision-making is purely rule-based and political. The French think that the appointment of a high-profile chief economist would help to correct this deficiency in the Commission. Some officials think that the French committee which examines the national budget – looking, for example, at the credibility of forecasts and figures – could serve as an example for a similar committee at EU level. Such a committee could also cover structural reform. The French also want the EU’s budgetary process to take into account the eurozone’s aggregate fiscal stance.

Reviving old ideas such as establishing a full-time Eurogroup president and giving the EU a role in national unemployment schemes. As one official put it, “the emphasis should be on carrots, not sticks – so no to Merkel’s reform contracts”. For the past few years the chancellor has been pushing the idea that the Commission should negotiate binding accords with each eurozone member, committing them to structural reform. But the official thought that a similar idea could work if given a positive spin: “Germany won’t agree to counter-cyclical policies at EU level, but why not incentivise structural reform in say Spain with a eurozone contribution to its unemployment benefits?”

Producing a ten-year plan for converging the eurozone economies. Like the Maastricht treaty scheme for the euro, this could have three phases, which would help to mobilise support. Politically, this would be an easier sell than Merkel’s contracts. To keep Germany happy, the plan could cover labour markets and the single market in goods and services; to keep France happy, it could cover tax (harmonising corporate tax bases) and social issues (how minimum wages are calculated). The plan could also deal with other prerequisites of growth, such as co-operation on industrial policy, digital markets, energy and R&D. Apparently the Commission is not enthusiastic about this convergence plan, though President Donald Tusk and the ECB are supportive. Some French officials are hopeful that the Germans – aware of the long-term challenges to their own growth model of high exports and low investment and consumption – could back such ideas.

French officials say it is not clear whether any of this may in the long run need treaty change, though they are adamant that for the time being they will resist attempts to revise the treaties.

The French do not expect the new Commission to be particularly helpful vis-à-vis the Germans. Many of them have a positive view of Jean-Claude Juncker, seeing him as more understanding of their problems than his predecessor, José Manuel Barroso. But they worry that so many of the Commission president’s chief advisers and senior colleagues (such as Valdis Dombrovskis and Jyrki Katainen) are ‘German’ in their thinking. Nobody is yet sure whether Pierre Moscovici, the French Commissioner for Economic and Financial Affairs, will prove influential. French officials are not particularly worried by the prospect of EU fines for their budget deficit; they assume they can go on negotiating with the Commission, making little adjustments to stave off punishment.

There is a lot of unhappiness in Paris about the ECB’s deference to Germany. Officials are frustrated with its inconsistency: it criticises in public the governments which borrow too much, yet although President Mario Draghi believes that Germany should adopt an expansionary fiscal policy, he will not say this unambiguously in public.

Amidst all this gloom, what strategy should the French pursue? They would certainly gain credibility in Berlin if they could show that they were controlling spending and implementing structural reform. But they believe they are caught in a vicious circle: Germany’s austerian policies – for both the EU and Germany – make it harder for France to grow, which worsens the fiscal position and makes painful reform politically more difficult.

The eurozone probably has to face a much deeper crisis before anything gets better. The Germans still believe that either fiscal or monetary easing would remove the pressure on countries like France to reform. But there may come a point when even the fiscal hawks of the German finance ministry have to acknowledge that the eurozone faces systemic difficulties (and not just policy errors in a few member-states). Negative growth and high unemployment, perhaps prompting social unrest, may impact on German thinking. If the current governments in Greece, Spain or Italy – all of which have more or less tolerated Germanic economics – were to collapse, bringing to power politicians opposed to the euro or to the German view of it, Berlin would have to compromise.

Thursday, December 04, 2014

On November 28th, David Cameron delivered a long-awaited speech addressing public concerns on EU migration. Its essence was not anti-European: the British prime minister underlined Britain’s long-term commitment to the principle of free movement, as one of the cornerstones of the single market. Having understood that quotas or ‘emergency brakes’ on EU migrants were unacceptable to all Britain’s partners (including German Chancellor Angela Merkel), Cameron pulled back at the last minute from proposing such ideas. He therefore upset hardline Conservative eurosceptics, who knew that if the UK made a cap on EU immigrants its chief negotiating demand, a British exit would become much more likely.

The prime minister’s speech included five proposals:

To deport EU job-seekers who have not found work within six months; and to stop such job-seekers accessing ‘universal credit’ (which will incorporate the current job-seeker’s allowance) when it is rolled out from 2015 onwards, for their first four years in Britain.

To impose a four-year period before EU migrants have access to in-work benefits like tax credits and housing benefit.

To stop workers in one EU member-state collecting child benefit there for children who live in another member-state.

To prevent workers from countries that join the EU from seeking work in the rest of the EU, until these countries’ economies have partially converged with those of the existing members.

To make it easier to deport criminals, fraudsters and beggars from other member-states, and to ban their re-entry.

Are these proposals achievable through new EU legislation, or would the Union’s treaties need amendment? And how likely is it that other member-states would agree to the changes?

The principles of free movement and the equal treatment of workers have been enshrined in the treaties, developed through secondary legislation in the form of directives and regulations, and extended by rulings of the European Court of Justice (ECJ). Any new or amended directives or regulations would have to be proposed by the European Commission and adopted by a majority in the Council of Ministers and the European Parliament. Amendments to secondary legislation that do not amount to discrimination between EU citizens and those of the host member-state would not require treaty revision. However, fundamental changes to secondary legislation that affect the principles of free movement and equal treatment would require treaty change and hence the unanimous agreement of 28 member-states. This distinction is crucial for understanding the legal and political feasibility of Cameron’s proposals.

Restricting the rights of job-seekers: The prime minister’s proposals lacked precision. First, he mentioned the possibility of requiring EU citizens to prove that they had a job offer before coming to the UK. This may have been a wish rather than a concrete proposal, but it would in any case be contrary to the treaties and impossible to implement in practice. Later, Cameron said that Britain would seek to deport EU migrants who failed to find a job within six months of entering the country. Other member-states have already considered this. Under EU law, EU citizens need to be working, studying, or self-sufficient in order to live legally in another member-state.

The ECJ, however, has extended some of these rights to job-seekers, so that EU migrants are allowed to live in a member-state if they can prove that they have a genuine chance of getting a job. According to the Court’s case law, member-states are permitted to limit the period for which unsuccessful job-seekers can access unemployment benefits. Therefore, restrictions on job-seekers, if not unconditional (that is to say, if they are not solely based on time limits, but they also take into account the migrant’s personal situation and their chances of finding a job) may well comply with EU law. They may also find some political support, notably from Western European member-states such as the Netherlands, Austria and Germany.

Cameron also said that he would stop EU migrants who had not yet worked in the UK from accessing the new ‘universal credit’, which will be introduced in 2015 if the Conservatives remain in power. This would mean they would have no access to unemployment benefit at all while looking for work in Britain. The ECJ’s case law has given job-seekers some rights of access to unemployment benefits, when they assist with integration into the host country’s labour market, so this proposal may put the government on collision course with the ECJ.

Limitations on EU migrants’ access to in-work benefits: The Conservatives may find it hard to impose temporary limits on EU migrants accessing in-work benefits: Article 45 of the Treaty on the Functioning of the European Union (TFEU) forbids discrimination against workers “as regards employment, remuneration and other conditions of work and employment”. Restricting migrants’ access to tax credits could amount to discrimination, since they are a condition of work and employment, and so the reform could require treaty change. Even if UK government lawyers managed to convince Brussels that tax credits should not be seen as a condition of work, and rather as social assistance or a tax advantage, a qualifying period would still be contrary to both a 2011 regulation on the freedom of movement for workers and ECJ case law. Reforming this regulation would need a revision of the underlying treaty principles, and hence require treaty change.

Stopping child benefits being paid to children abroad: Under current EU rules, the children of EU parents working in the UK are entitled to receive child benefits from the UK, regardless of where those children live, provided that neither parent works and lives abroad with the children. This rule is part of a 2004 regulation that addresses situations where the children of EU workers do not live with their parents. Several EU governments support reform of this regulation. Nevertheless to stop EU citizens from accessing child benefits in certain circumstances could be considered as discrimination against EU workers – so some would argue that it required treaty change.

Temporary restrictions on workers coming from new member-states: This proposal should be much less problematic: imposing restrictions on workers coming from new member-states until “their economies have converged with the existing member-states”, as Cameron put it, would be legally and politically feasible. Workers from Romania and Bulgaria faced temporary restrictions on their right to free movement for a period of seven years after those countries acceded. Since accession treaties require the unanimous agreement of all member-states, the UK could, if it wished, insist on restrictions that endured until the accession state’s per capita income had reached a certain percentage of the EU average. But this proposal will not make much difference in the short term: no country is due to join the EU in the next five years.

Expulsion and re-entry bans on EU criminals, beggars and fraudsters: On December 1st the UK opted back into 35 measures of police and judicial co-operation (such as the Schengen Information System and the European Arrest Warrant), which help governments to exercise tighter controls over convicted and suspected criminals across the EU. The current migration debate makes the case for opting back into these measures even clearer: the more police and judicial co-operation there is, the more control the UK will have over EU criminals entering the country, including fraudsters. The ‘citizens directive’ allows member-states to expel EU citizens on the grounds of public policy or public security. Member-states can also ban expelled EU citizens from re-entering the country.

The ‘citizens directive’, however, requires a case by case analysis of expulsion and re-entry bans, and offers a system of procedural guarantees to ensure that EU citizens are protected from arbitrary expulsions and expulsions en masse. Article 27 of the directive has incorporated the ECJ’s case law and says that a criminal conviction is not sufficient reason to expel an EU citizen. Furthermore, the grounds for expulsion cannot be “invoked to serve economic ends”. Therefore, the UK, like any other member-state, is allowed to expel EU citizens on the basis of public policy or security, provided that the decision is based on a solid examination of the citizen’s personal circumstances. Indiscriminate expulsions of criminals, fraudsters or beggars are not allowed under EU law and would require legislative change, although probably not a revision of the treaties.

In sum, several of Cameron’s proposals might require treaty change in order to be legally watertight, since they would discriminate against EU workers. Indeed, Cameron himself said that treaty change would be necessary. In particular, imposing temporary restrictions on access to in-work benefits and expelling job-seekers after six months might violate the principles of the free movement of workers and equality of treatment. Banning parents from drawing child benefits for children abroad could also be regarded as an obstacle to the free movement of workers and might require treaty change.

The UK could, however, try to achieve limited reforms to the rules on access to benefits which would be both treaty-compliant and politically attractive to some other governments; for example, limiting the time that job-seekers can stay in the UK when they have failed to prove that they have a real chance of finding employment or that they are actively looking for a job. The UK could certainly impose restrictions on the right of free movement of workers from future accession countries. Britain can exercise more stringent controls on EU criminals entering the country through the effective implementation of the 35 JHA measures the government has just opted back into. The UK does not need to change EU law in order to expel criminals from its territory, since the ‘citizens directive’ already allows for it.

Cameron will still have to contend with the possibility of the European Court of Justice scrutinising secondary legislation that challenges the principle of free movement. The ECJ has in the past sought to extend the rights of EU citizens working or looking for work in other member-states. Amendments to secondary legislation could be quashed by the Court, on the basis of its interpretation of the treaties. That is why in the long run Cameron may need to underpin several of his proposals by treaty change.

Changing the treaties through the normal method – the holding of a convention of MEPs, national parliamentarians and government representatives, followed by an inter-governmental conference (IGC) leading to an unanimous agreement among 28 member-states, each of which then has to ratify the new treaty – would take many years. At the moment virtually no member-state other than Britain has an appetite for treaty change. Many of them fear that parliaments or electorates (in those countries that would need to hold referendums) would reject the changes, given the strength of eurosceptic feeling in much of Europe. Furthermore, the economic situation in the eurozone, though far from healthy, is not so dire that its leaders believe its rules must be revised in a new treaty. Governments are also reticent because they know that embarking on treaty change would be like opening Pandora’s Box: almost every government has demands that it wishes to see fulfilled in a new treaty. There is no chance of getting a major new treaty ratified by Cameron’s self-imposed referendum deadline of 2017.

Could Cameron find a speedier method? Possibly. The ‘simplified procedure’ allows changes to internal policies that do not involve the transfer of competences to the EU. Under this procedure, EU leaders could dispense with the convention and the IGC. But the procedure cannot be activated without a unanimous agreement to do so, and then the new text still has to be agreed unanimously and then ratified by all members. None of which would be quick or easy.

Probably the only sort of ‘treaty change’ that is feasible by 2017 is a political agreement among heads of government to make specific changes in the future. British officials are thinking about emulating the method used to deal with Ireland’s rejection of the Lisbon treaty in the referendum of 2008. A protocol was drawn up, with language that reassured Ireland over the Lisbon treaty’s provisions on abortion, tax and neutrality. These reassurances helped to persuade the Irish to vote Yes in a second referendum – though they had to wait for the Croatian accession treaty, to which the Irish protocol was tied, before the protocol became legally binding.

If the UK aims to change the rules through this kind of ‘post-dated cheque’, it will face many problems. In a referendum campaign in 2017, would voters believe promises of change that depended on other countries ratifying future treaties? Furthermore, the provisions of the Irish protocol were uncontroversial. Any British attempt to push through the revision of EU rules on free movement via a similar protocol – requiring unanimity – would be fraught. Central European governments have already criticised some of Cameron’s ideas, but many in Western and Southern Europe will also oppose attempts to undermine free movement for workers and job-seekers.

If Cameron bangs the table, resorts to Eurosceptic rhetoric and challenges the principle of free movement, he may achieve very little. But if he embarks on a charm offensive in Europe, building alliances and forging friendships with other EU leaders, he may be able to achieve parts of his package.

Camino Mortera-Martinez is a research fellow at the Centre for European Reform.

Tuesday, December 02, 2014

For many years, the debate about whether the European Central Bank (ECB) was too heavily influenced by Germany was confined to academic papers. As of late, it has become the central policy question of the eurozone. Germany is more influential at the ECB than it should be. In fact, Mario Draghi’s penchant for seeking German approval has been his biggest mistake as head of the ECB. He should end it. If he waits until the German public comes around to looser ECB policy, it might be too late, as the seemingly unstoppable fall in inflation and the eurozone’s weak growth prospects show. The Bundesbank, rather than torpedoing reasonable ECB decisions, should throw its weight behind a more expansionary monetary policy and back the ECB.

The ECB was modelled on the German Bundesbank. As a result, it is one of the world’s most politically independent central banks; its mandate is focused narrowly on price stability; it does not take broader economic goals like unemployment into account in the way other central banks, such as the Fed, do; and it is de facto more restricted than other central banks, since controversial measures can lead to complex political and legal struggles, involving 18 (soon to be 19) countries. Its setup and philosophy are therefore ‘German‘, that is, conservative and cautious.

In terms of the ECB’s conduct of monetary policy, it is worth distinguishing between the pre- and post-crisis periods. A wide range of studies have so far failed to establish a firm consensus on the influence of various countries on the ECB during the euro’s first decade. However, most studies have found that the ECB behaved like a multinational central bank, in which each country has a weight proportional to the size of its economy. This gave Germany a higher weight than other countries because it is the largest economy in the eurozone. But it is hard to argue that there was a German bias at the ECB before the crisis.

In the post-crisis period, the ECB has failed to stabilise the economy, and inflation has fallen to just 0.3 per cent. It is tempting to see this as the product of a German bias, because the German economy has suffered least from the ECB’s hesitation to do more. But it is hard to argue that German pressure prevented the ECB from lowering rates faster during the last two years, for example, or managing the inflation expectations of consumers and investors more aggressively. Rather, the ECB’s misjudgement of the economic dynamic in the eurozone prevented a more timely and aggressive stance.

However, now that the ECB has to move further into unconventional territory to correct its previous errors – potentially by buying government bonds – Draghi has taken German resistance into account and delayed quantitative easing (QE). German policy-makers and commentators argue that further monetary easing will not stimulate the eurozone economy much, but risks encouraging excessive risk-taking and asset price bubbles that could breed future crises. They also claim that buying government bonds would lower the pressure on governments to reform, and adjust their economies and budgets.

This raises the question of why German approval is needed at all. In the governing council of the ECB, all relevant monetary policy decisions are taken by simple majority, with the smaller countries having one vote each, and the larger countries traditionally two (because of the additional votes of executive board members). Some of the more fundamental decisions, like recapitalising the ECB, need a two-thirds majority, based on the ECB’s capital shares, but even then Germany has no veto. What is more, there is currently a clear majority for more aggressive ECB action in the council, which Draghi can draw upon whenever he decides that the time is right. Formally, there is no need for German approval, either from Berlin or from the Bundesbank.

Why, then, is Draghi waiting for German approval? There are two possible reasons. First, he might consider it unwise to conduct monetary policy in the face of opposition from the largest eurozone country. There is some merit to this view but it loses validity when the ECB is failing to fulfil its inflation mandate by a wide margin, as it is now. Not only is inflation below the target of 'just below, but close to 2 per cent inflation'; expectations of future inflation have fallen steeply – a source of alarm even to conservative central bankers. Expanding the scope of monetary policy is therefore a matter of urgency, regardless of which country is opposed. It is with good reason that the statute of the ECB is not limited to a narrow definition of monetary policy but allows the purchase of ‘marketable assets’, including government bonds in the secondary market.

In such circumstances, Draghi should not let himself be bullied by the macroeconomic views of a single, if powerful country – views that few share outside Germany. Even the relatively cautious OECD has now come out in favour of further monetary stimulus, and the IMF has been urging the ECB to do more for a while. Given that the Fed and the Bank of England have bought government bonds on a massive scale, the ECB would be well in line with consensus views on monetary policy if it did the same.

The second reason why Draghi might want to get Germany’s backing is that he may fear losing the German government’s consent for the ECB’s other operations, which are not strictly monetary policy. The most important of these, of course, is the OMT programme, which was announced during a panic-driven run on eurozone government bonds in the summer of 2012. The ECB declared that it intended to buy unlimited quantities of these bonds if the panic did not subside – which it then duly did. This programme makes the ECB the implicit guardian of the eurozone as the lender of last resort to governments, but the OMT is in part a fiscal operation. Without the support of Germany, the country with the deepest pockets, the OMT might fail. Draghi therefore does not need the Bundesbank’s support but that of Merkel and the German government – which has backed him on the OMT.

However, Germany’s attitude towards the OMT should not be misunderstood. The German government understood very well that the eurozone might collapse if the ECB did not intervene in the summer of 2012. In fact, one could hear a collective sigh of relief (some say the sound of popping champagne bottles) in Berlin after the ECB took on the de facto role as lender of last resort to sovereigns – despite shrill German press coverage warning against such a step. Regardless of whether the German government approves of further easing of monetary policy, it would still back the OMT. Draghi should therefore not be overly concerned that further, unconventional monetary easing would threaten his role as guardian of the eurozone.

The outstanding legal challenges to the OMT do not change this. Even if the German constitutional court were to forbid the Bundesbank to take part in such a programme in the end – a drastic but conceivable outcome – the basic idea behind the OMT would still survive. The question that the OMT has answered is how far Germany would go to save the eurozone from breakup. Germany has tacitly approved the nuclear option, using the very deep pockets of the ECB as a backstop for government bonds. Even if the legal details of the OMT programme turn out to be tricky, this answer is still the same: Germany and the ECB are determined to avoid a break-up of the eurozone and a panic-driven run on eurozone government bonds. The history of the euro crisis shows that if there is a will, European policy-makers remove the legal roadblocks that might stand in the way. The market will therefore not bet against Germany’s and the ECB’s resolve to keep the eurozone intact.

Waiting for German consent has been Draghi’s biggest mistake in office, since waiting imposes considerable costs. The most important task of a central bank is to keep the expectations of consumers, firms and investors about the future state of the economy on a reasonably optimistic path. Waiting for German approval in the face of a weakening economy undermines these expectations, making the job of lifting expectations that much harder, once the central bank does decide to act. Draghi has wasted precious time – the ECB should have started to act aggressively in spring 2013 – and is now being forced to use controversial measures on a large scale to turn the economy around. Whether those measures will succeed is still uncertain.

Draghi is not the only one to blame, however. The Bundesbank enjoys huge credibility in the German public. It could easily stand publicly behind the ECB and thus foster an environment in which the ECB can act more aggressively, which most economists agree is desperately needed. At the very least, Jens Weidmann, the head of the Bundesbank, needs to stop undermining the ECB in the eyes of the German public. Likewise, Wolfgang Schäuble, Germany’s finance minister, and Angela Merkel should back the ECB openly, and pressure the Bundesbank to do likewise. After all, one reason for the weak state of the eurozone economy is Germany’s reluctance to accept more expansionary fiscal policies in the eurozone and at home.

Christian Odendahl is chief economist at the Centre for European Reform.

Monday, December 01, 2014

Last Wednesday Jean-Claude Juncker, the president of the European Commission, announced his plan to create a €315 billion ‘European Fund for Strategic Investment’ to try to stimulate the European economy. It will take the form of an investment fund; €21 billion will be taken from the EU budget and the European Investment Bank to act as the fund’s capital. This will be used to offer guarantees that will reduce risk for private investors. The hope is that this will stimulate private lending to infrastructure and research and development, and take the value of investment over €300 billion.

That figure looks impressive, but the fund is unlikely to have much impact on growth. This is because it has been designed to avoid any new public borrowing for investment. There is no new public spending – pre-existing funds are being shuffled into the programme. So new spending will have to come as a result of loans from the private sector. Juncker hopes that the capital of the fund can be ‘leveraged’ by 15 times, meaning that the value of private lending will dwarf the public capital that has been committed. This would be double the leverage ratio of the European Stability Mechanism, and infrastructure investments are often more risky than lending to governments, which should reduce private investors’ willingness to lend to the fund. Finally, member-states can inject more capital into the fund if they wish, and these investments will be excluded from their deficit targets under the eurozone’s fiscal rules. But they are unlikely to do so, since the European Investment Bank will pick the projects that will be funded, and so governments’ capital will be mostly used in other member-states.

It may seem pointless to argue for a more sensible investment strategy, since it would require counter-cyclical government investment of the type that the eurozone has repeatedly rejected. But the case for such a strategy is strong. Instead of fiddling with financial engineering, eurozone member-states should simply borrow money directly from the markets and invest it themselves. There is little need for the Commission or European Investment Bank to be involved. Member-states need to co-ordinate on the size of the stimulus – Germany providing some stimulus on its own will not be enough – but they do not need a common instrument to do so. The eurozone is in the last-chance saloon: unless it starts to grow, and unless inflation rises, public sector debt will become uncontrollably large in some member-states. And, counter-intuitively, more public investment would reduce the burden of debt, not raise it.

The eurozone economy has stagnated for three years: in real terms, it is now slightly smaller than it was in the first quarter of 2011, and is still 2 percent below its peak in the first quarter of 2008. Inflation is very low, at 0.4 per cent. Unemployment is stuck above 11 per cent. But policy-makers have done little in response. Mario Draghi, the president of the European Central Bank, has continued to try to improve inflation expectations through talk rather than through action: the ECB is yet to embark on quantitative easing.

Meanwhile, eurozone countries remain committed to fiscal targets (limiting structural budget deficits – the deficit adjusted for the economic cycle – to below 0.5 per cent) that tightly circumscribe their freedom to go for a fiscal stimulus. Fortunately, fiscal policy will contribute a little to growth across the eurozone between 2015 and 2016, as France, Italy and Spain have successfully won more time to comply with these rules (see Chart 1). However, there is no indication that the eurozone is close to launching a meaningful fiscal stimulus.

Chart 1. Eurozone structural government deficits

Source: European Commission/Haver

Member-states should not merely stop digging. The eurozone needs a fiscal boost, alongside more unconventional monetary policy, to kick-start growth and raise inflation. As ever, the biggest obstacle to such a programme is Germany, which has been facing increasingly desperate calls to stimulate the eurozone economy through a programme of public investment at home. It has been running down its infrastructure for over a decade. It can borrow money, essentially for free, since yields on its long-dated debt are lower than expected inflation.

Berlin’s stock response is that a German investment stimulus would do little to boost the eurozone economy as a whole. They point to research that suggests the impact of a German programme of fiscal stimulus on other member-states would be small. According to the ECB, a 1 percentage point increase in German government spending would only boost French GDP by 0.03 per cent.

However, other researchers have shown that the spillover effects would be bigger. In a 2013 paper, Jan in’t Veld, an economist at the European Commission, questioned the method of studies that found little benefit for Germany going it alone. He pointed out that they did not include important factors that would make their models more realistic under current conditions: a far larger proportion of households than usual lack access to credit, for example, and the ECB’s interest rates are effectively at zero. When these factors were included in the model, the spillovers were higher, at between 0.2 per cent for France, Italy and Spain, rising to 0.3 per cent for Ireland. The IMF found that the effect would be of a similar size. This suggests that a German stimulus would have a moderate impact on output in other countries, and is worth pursuing for both domestic reasons and for the benefit of the eurozone as a whole.

However, as the Oxford University economist Simon Wren-Lewis notes, a fiscal stimulus in the eurozone would be more beneficial the more countries participated in it. To understand why, consider the effect on GDP of the eurozone’s co-ordinated austerity programmes since 2010. In’t Veld found this effect to have been very large. In Germany, Ireland and the rest of the eurozone ‘core’ of Belgium, the Netherlands, Austria and Finland, simultaneous austerity more than doubled the impact on output compared to austerity pursued alone. In France, Italy and Spain – larger economies that are slightly less open to trade – the impact was around 40 per cent bigger. Why is that the case? Austerity leaks into other member-states, since it reduces demand for other eurozone member-states’ exports. If a member-state cuts its deficit alone, reducing demand for imports, that reduced demand is shared across its trading partners, which makes the effects fairly modest. But if every country imposes austerity at the same time, the effect on imports is much larger. The obvious lesson is that simultaneous fiscal stimulus (as opposed to rectitude) will have much larger effects on output than if Germany acted alone.

Many in Frankfurt, Berlin and Brussels argue that any co-ordinated stimulus beyond the core would be far too risky, since the ‘periphery’ cannot afford to take on more debt. But the ECB, through its ‘Outright Monetary Transactions’ programme, has reduced the risk that a country might be forced to leave the eurozone, at least for now. It has promised to act as a lender of last resort to eurozone governments – which brings the eurozone into line with other developed countries – and as a result, borrowing costs for governments have fallen. Chart 2 shows the average interest rate on existing stocks of government debt. Government borrowing costs have fallen rapidly since 2012, with Italy and Spain’s average debt service costs as low as Germany’s were in 2009. These countries do not face a funding crisis.

Chart 2. Average interest rate on stock of existing debt

Source: ECB

Now that the ECB has given the eurozone the chance to pursue a broad-based fiscal stimulus, it should use it. The most sensible thing to do would be to invest in energy, transport, digital networks and other forms of infrastructure. Public spending in these areas has a high ‘multiplier’ – meaning that it raises GDP by more than tax cuts or other forms of spending. This is because little of the money is saved, as with tax cuts. Moreover, government investment leads to higher levels of private investment. A new road linking businesses and consumers, or employers and workers, will create economic activity.

There is not a shortage of things to invest in, especially in Italy and Germany. The quality of Italian infrastructure is far lower than its competitors: the IMF gives it 3.9 out of 7 compared to France’s 6.4. The quality of Germany’s infrastructure is high, but has been falling steadily since 2006 – especially its roads, which are now at the G7 average.

The case for increased infrastructure spending in Spain and France is less obvious: France has sensibly maintained its infrastructure spending, unlike other countries, and has the best infrastructure in the G7. Spain invested too much in physical infrastructure in the boom years. However, investment in human capital might be a replacement. But both countries have higher youth unemployment than the OECD average, and the quality of vocational and tertiary education for young people who have done poorly at high school in both France and Spain is bad.

In its latest World Economic Outlook, the IMF calculated that the multiplier on debt-financed government investment in developed economies, under the prevailing depressed economic conditions, would be so large that:

a 1 percentage point of GDP increase in public investment would raise output by 2 per cent in the short term, rising to 3 per cent in the long term, as the supply capacity of the economy expanded;

and such a stimulus would reduce public debt by 1.6 percentage points for a ‘high efficiency’ investment programme – which means investments that bring in higher taxes – and by 0.6 percentage points for a ‘low efficiency’ one.

The stumbling block is the eurozone’s fiscal rules. Earlier this month, France and Italy demanded more time to meet them – even, in Italy’s case, demanding a small stimulus in the short-term. For its part, the Commission insisted that they cut their deficits, but by less than it had originally demanded.

This exercise in haggling makes one thing clear: that the eurozone’s fiscal rules have not been abandoned, as some commentators suggest. They may not be followed to the letter, but, unless member-states insist that the rules are abandoned or reformed, a sensible counter-cyclical fiscal policy will not be forthcoming.

There are two ways to reform the rules to make them less pro-cyclical. The first would be to cite the Stability and Growth Pact’s ‘exceptional circumstances’ clause, which allows member-states to breach the 3 per cent limit on budget deficits in “periods of severe economic downturn for the euro area or the EU as a whole.” The current depressed state of the eurozone econmy surely counts as such a period. A more radical option – and therefore one that is more unpalatable for the eurozone’s creditor countries – would be to supplement the existing fiscal rules with a ‘golden rule’, which would allow governments to borrow to invest over the economic cycle. This would remove investment from the eurozone’s fiscal framework altogether. This should have been the case from the start, since, under the current framework, public investment has been slashed more than other forms of spending, despite its high multiplier.

This modest proposal, which is founded in economic theory and evidence, will no doubt be ignored or rebuffed by the austerians, as though it were akin to Jonathan Swift’s proposal three centuries ago (that the problem of an Irish famine could be solved by parents eating their children). The problem is that, unless the eurozone treats ‘lowflation’ as the emergency that it is, debt restructuring will eventually become inevitable. But, unless Germany joins the rest of the eurozone core and the ECB in doing all they can to raise growth and inflation, the effort will fail. This is the tragedy of the eurozone: its member-states are bound together, and can only escape with the help of Berlin, Frankfurt and Brussels. That help is unlikely to be forthcoming. But it does not weaken the case for public investment, as part of a broader attempt to pull the eurozone economy off the rocks.

John Springford is a senior research fellow at the Centre for European Reform.